The independence vote heralded political and economic disaster. Existential uncertainty now faces the region's oil sector

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When he proceeded with the independence referendum in September, the Kurdistan Region of Iraq's President Massoud Barzani misread the post-Islamic State moment, alienated international allies and stirred Baghdad's animosity. Friendless and out-gunned, the KRI's Peshmerga forces capitulated when Iraqi federal troops swept into the contested city of Kirkuk and a vast belt of disputed territories across northern Iraq in mid-October.

Soon after, the KRI lost 280,000 barrels a day of oil production and around 6bn barrels in proven reserves when Iraqi forces restored Baghdad's control of the Bai Hassan oilfield and the Avana Dome of the Kirkuk field. They kicked out KRI-appointed contractor Kar Group, re-installing federal North Oil Company (NOC) engineers who had left when the KRI captured the fields in 2014.

At the time of writing, Bai Hassan and Avana Dome production was shut in: NOC workers couldn't operate equipment installed by Kar after 2014. Oil from other Kirkuk fields had stopped flowing into the KRI's export system. This left the KRI with a reduced slate of oil assets, and cut the size of its oil sector in half. Pipeline exports collapsed from around 580,000 b/d to about 250,000 b/d.

Baghdad also threatened to enter the strategic northwestern corner of Iraq, severing the KRI's independent pipeline access to Ceyhan. The military advance stopped short in early November under heavy US pressure.

What does this mean for 2018? As ever in Iraq, it's unwise to make assumptions too far into the future, though the loss of Bai Hassan and Avana alone kills any hope of economic independence for the foreseeable. The fields comprised 45% of independent export volumes, and a large share of the KRI's oil-growth potential. The Iraqi Kurdish oil ministry had mortgaged the region's future on oil-supply agreements with traders, predicated on output from these fields. The cheap oil provided a subsidy allowing the KRI to at last pay upstream producers their contractual dues, after years of bilking them.

All that may soon come an end. While the KRI made payments on time in October and November, it's bankrupt, and can't afford to pay $100m a month—around a third of independent oil revenues—to producers. And the region has less than half the oil it needs to meet supply commitments.

It could have been different. By late summer, pipeline exports to Turkey's port of Ceyhan consistently flowed at around 560,000 b/d, with another 38,000 b/d of heavy oil trucked to another Turkish port. Risk premiums on KRI cargoes had all but disappeared from the region's lynchpin buyers in the Mediterranean.

The loss of Bai Hassan and Avana alone kills any hope of economic independence

Things had also been looking up for KRI gas. Pearl Petroleum, the region's largest gas investor, settled arbitration claims it pegged at almost $30bn and committed to reinvestment, thanks to $1.3bn fronted to Pearl on behalf of the KRI by Rosneft as the Russian giant waded in to Kurdish oil buying. Pearl acquired more acreage, partial payments and better contract terms.

In addition to oil advances, Ashti Hawrami, the KRI's minister of natural resources, secured strategic pipeline interest from Rosneft, to build an export gas link to Turkey and boost the capacity of Kurdistan's existing oil pipeline. Control of these pipelines insinuates Russia into an enclave that had previously been a ward of American support.

Consolidating federal control, Iraqi prime minister Haider al-Abadi now aims to restore the state monopoly on oil exports. A return to the national budget system —under which the KRI will have to allocate export oil for a share of planned national spending—will prevent it from supplying traders and rob it of control over revenues. Upstream operators received only small and erratic payments when the KRI last came under the budget. It's unclear if Baghdad will take responsibility to pay KRI operators, whose contracts they still don't endorse. If payments stop, disinvestment and a return to operator-driven shut-ins could follow.

Baghdad doesn't consider itself obliged to meet the KRI's oil-supply commitments to traders, or to honour the KRI's other debts, including around $3bn in soft loans and overdue pipeline fees to Turkey. Worse, the referendum brought Baghdad and Ankara into line against the KRI, raising the prospect that effective control of the Ceyhan terminal could revert to Baghdad.

Oil investors hope the KRI, with American support, can persuade Baghdad to carve out oil from its internationally operated fields to be marketed independently. A deal is needed, urgently, but may prove elusive. Ahead of May 2018 elections, Abadi has little incentive to pay the Kurds, or play ball. He has not taken calls from Erbil so far.

Before a new oil deal with Baghdad can be hammered out, Kurdistan must also get its house in order. Massoud Barzani notionally quit as president, though he remains in power, doing little to tidy the mess besides hand it to his nephew, Nechirvan, the prime minister. He has staked some hope on Russia, sensing the need for a new patron having mistaken his role as security contractor against IS on the US' behalf for something more. But allowing Rosneft to corner Kurdish energy on the cheap would pile one mistake on another.

Patrick Osgood is an independent Iraq energy journalist and researcher

This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy,click here